Now Jen is on a mission to inspire and empower others through financial education so they too can enjoy the life they want to live. Jen shares her recipe for success, happiness and financial freedom via writing, blogging, speaking and coaching. As part of her commitment to community, Jen pledges her blogging profits as 0% microloans through Kiva.org to small businesses operated by working, impoverished women in developing countries.

Will the Great Recession Trigger the End of Buy-and-Hold Investing?

More specifically, does the commonly given investing advice to “buy and hold” really work? Or have the rules changed?

During the past several decades, the prevailing advice has been something like this:

“Diversify your investments, buy stock in good companies, and hold them until you retire. The value of stocks (and real estate) always go up over time.”

Sure they do… until they don’t.

People who steadfastly held onto their stock portfolio from peak (10/9/07 DJIA at 14,164) to most recent trough (3/9/09 DJIA at 6,547) saw almost 54% of their portfolio vanish.

In just 17 months, over 12 YEARS of DJIA gain disappeared. (DJIA closed at 6528 on 11/26/96.)

Buy-and-hold investors would need to see a gain of more than 116% to bring their portfolio back to the 10/9/07 DJIA peak (14,164) from the latest DJIA valley (6,547).

Of course, those who diversified among various asset classes and markets will come up with different numbers, but this is a global recession. Diversification helps very little when everything is falling. There have been very few places to hide, much less make a profit.

It really bothered me to hear financial advisers and personal finance bloggers recommend people stay the course and hold onto their stocks — and even buy more — as prices were falling. While real estate and the markets generally do rise over the long term, that is not much consolation if your retirement is near. Buy-and-hold investing has put those who are retired, or are close to retirement, in a huge pickle because they don’t have time on their side to recoup such giant losses.

I’m lucky that I don’t buy into the buy-and-hold hype. I used to, though, and I paid the price. Remember, no one, not even your investment adviser, cares as much about your money than YOU do.

During the first six months of 2008, I incrementally moved most of our stock portfolio to the safety of FDIC-insured cash accounts, limiting our losses to less than half as much as the buy-and-hold-ers have suffered. I follow momentum trends in the market, and as the trends were heading downwards, I got out and headed for safety. Buy-and-hold investors use a passive strategy; I limit my losses by actively and systematically managing our portfolio. I invest to make money, not to sit back and watch as it all disappears.

Before the Great Recession, I was able to profit by keeping my portfolio 100% invested. This has been the first time I’ve ever held cash in our long-term portfolio. Up until this Great Recession, there were always some sectors and markets trending upwards, even as others were tanking. Momentum trend investing kept my money working for me, moving to the new market leaders as they emerged.

The investing strategy I use assigns a score to no-load mutual funds based on their 1, 3, 6 and 12 month returns. I will remain parked in cash until markets show consistent upward momentum trends, triggering the scoring system to indicate positive numbers again. Then I will move my cash incrementally and systematically into equities.

If you’ve made it this far into my article, kudos! I know that investing jargon can be hard to wrap your head around. To help explain — and review — how I choose to invest, in a fun, story kind of way, please read a reprint of an article I wrote on my old blog in March 2008, when I was in the process of moving out of equities and into cash:

How I Make Money Following the Herd: The Trend is My Friend

(photo by p.joran)

A couple of days ago (Ed: this would have been in March 2008), I ranted about the financial herd behavior that created the unsustainable housing market bubble. But today, I have a confession to make that might make me sound like a hypocrite. Allow me to explain by way of comparison with one of my previous hobbies.

When we lived on a small hobby farm, I participated in stock-dog herding trials. Did you ever see the movie, Babe? Yep, me and my faithful Border Collie moved a flock of sheep across fields, around fences, and into small pens. We often competed in shows to demonstrate our skill and teamwork.

As long as my dog and I kept the flock of sheep moving together as one unit, we could herd them anywhere. Their desire to stay together was intense. Though we never tried it, of course, we probably could have moved them straight off the edge of a cliff — as long as the flock did it together.

The investment strategy that I’ve been using for the last several years involves following the same “herd” that often drives me nuts. Yep, I purposely join the very same herd that creates unsustainable and irrational market bubbles.

But here’s the critical difference — I bail out of the herd when they start flinging themselves off the cliff.

At first glance, this might sound like market timing. And we know how difficult it is to time the market successfully. I don’t have the time nor desire to be a day-trader, either. So what is the difference between market timing and the investment strategy I use?

“Market timing is the strategy of making buy or sell decisions of financial assets (often stocks) by attempting to predict future market price movements.”

So I’m not a market-timer because I don’t aim to forecast the market. I look at what the market is doing, not what the market might do. I enter the market after a trend properly establishes itself. I jump on the trend and ride with it. (Baa… Baa… Baa!) If there is a persistent turn contrary to the trend, I follow a mathematical signal and exit that trend.

I’ll explain this by returning back to my sheep herding analogy:

I join the already formed flock after it’s developed direction and momentum. I follow the flock as it heads towards greener pastures. I watch the front of the flock. If the leaders of the flock start to stampede off a cliff, I bail out and take a different direction. I look for another forward-moving flock to follow.

I don’t think momentum investing is in vogue with the majority of individual investors. If I had to guess what is most popular, I’d say it’s the passive strategy of buy-and-holdindex investing. I am a previous buy-and-hold index fund investor myself. There is nothing “wrong” with this strategy. After all, the long-term trend (note the word “trend” again) of holding the total market is up. A buy-and-hold-index portfolio is easy to manage, enjoys low expenses, and often saves on taxes.

Every trader needs a trend to make money. If you think about it, no matter what the technique, if there is not a trend after you buy, then you will not be able to sell at higher prices…”Following” is the next part of the term. We use this word because trend followers always wait for the trend to shift first, then “follow” it.

Van K. Tharp, author of Trade Your Way to Financial Freedom

Momentum investing is different than buy-and-hold because it exploits investor herding behavior. As a previous shepherd, I intuitively understand this concept. Rather than buy-and-hold the total market through all of its peaks and valleys, I baa-baa-baa my way to the bank.

The ultimate goal of investing is often touted as buy low and sell high. Some would argue that today’s market provides an excellent time to buy while share prices are comparatively low; and that selling now could be locking in losses.

Conversely, by following a momentum strategy, I aim to buy as shares move up and sell them when even higher.

Richard Driehaus, the founder of Driehaus Capital Management, Inc., is widely considered the father of momentum investing. This Chicago money manager takes exception with the old stock market adage of buying low and selling high. According to him, “far more money is made buying high and selling at even higher prices.

Richard Farleigh, author of Taming the Lion, showed that markets continued in an existing direction around 55% of the time and reversed themselves the other 45%.

Similarly, Dal Company (NoLoad FundX) states that “Upgrading outperforms the market, as measured by the S&P 500, only about 55% of the time when measured on a monthly basis. But we end up far ahead in the long run because when we outperform, we do so by a larger measure than when we underperform.”

Now that might not sound like much, but for an investor 10pc represents a massive advantage. If you get 55pc of your calls right and manage your portfolio properly by riding winners and cutting losers you will make a lot of money.

So what does this mean for the investor? First, it argues against contrarian investing, which says you should look for opportunities where the market has overshot one way or the other. If prices move with the trend more than half the time, you start your search with an immediate handicap.

…stick with your winners. Trends go on for a lot longer than you might expect.

What does the “flock” indicate about today’s market conditions? How am I responding with my own investment portfolio?

In sheep herding terms: When a Border Collie puts too much pressure on the flock by moving too quickly or too erratically, the flock panics and sheep scatter everywhere. Sometimes individual sheep get hurt in the mayhem.

Investing: Wall Street shows the market swinging wildly up one day, wildly down the next, back and forth. Investors are feeling too much pressure. Panic is prevalent and money is scattering here, there and everywhere.

In sheep herding terms: When sheep scatter, the shepherd instructs the dog to stop dead in their tracks for a moment to allow the sheep to get over their panic and drift together to form an orderly flock once again.

Investing: Market trends have all but disappeared at the moment and little seems to “stick”. By halting my investing temporarily, I’m waiting for investors to stop their panicked scatter, calm down, and form identifiable trends once again.

In sheep herding terms: When the flock is calm and moving together again, the shepherd instructs the dog to get up and move forward.

Investing: When investors and the market have calmed down, stabilized, and show cohesive movement in identifiable sectors, I will resume my momentum investing by following the new market leaders.

How do I control risk?

I’m diversified. I invest in mutual funds and ETFs. I limit any one mutual fund or ETF holding to a maximum of 10% each (5% max. in more speculative sectors).

I’m systematic. I have predetermined entry and exit marks that help to keep me from reacting emotionally. I limit my upgrading to once or twice per month.

I cut my losses. During periods of high market volatility, I reduce my exposure to the market by cutting back on my positions. My objective is to preserve capital until more positive price trends reappear.

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Disclaimer: My investment strategy and portfolio allocations are not right for everyone and should not be construed as advice. If you’re not sure how much risk to take, or whether your investments accurately reflect your life goals or appropriate timeframe, get some individualized help. Many 401(k) providers have investment professionals available to talk to participants about their allocations. Or consider talking with a fee-only financial planner. You can find one online at the web site of the National Association of Personal Financial Advisors, or the Garrett Planning Network, a group of advisors who charge by the hour.

20 thoughts on “Will the Great Recession Trigger the End of Buy-and-Hold Investing?”

Interesting that this quite long blog entry — pretty typical that it concentrates on the Stock Market — the media constantly refers to the market, and companies like Charles Schwab who advertise directly to the general public and they do a good job at it.

Consider that your 401k and IRA invested in the stock market will grow at an average rate of about 8% over the long-term. While you don’t pay taxes on the money you put in, you do put 100% dollars into this investment (we’ll discuss this later). Don’t forget to reduce that growth by at least 1%, perhaps even 2-3% depending on how well you chose your fund for all of the fees that they charge you. So, the actual growth might only be 5%, just barely above a 4% inflation rate. RMD’s force you to take money out (congress wants their tax money eventually). Then it will be taxed. Taxed at probably 25% federal rate, and if you live in CA like I do, maybe that total is about 30% on top of the fees you’ve been paying all these years. Wow, that’s a huge cut, and no deductions on taxes.

Now check out Real Estate. It’s not easy. It’s way more hands on. Put down 10% on a duplex (only 10% of your hard earned dollars). You’re likely to be showing positive cash flow pretty quickly since duplexes don’t cost much more than a SFR, but generate 30-40% more in rents. Use that cash flow to buy another one. And, then another one. Managing these units takes time; we found that my work pays the bills, and my wife works hard as a property manager (which saves us 8-10%). Working for you is: appreciation (generally around 4%), depreciation (which drops the taxes you pay every year for 27.5 years!), we even paid for a Chattel Analysis for even more depreciation, someone else pays the mortgage, property taxes and insurance, business expenses to deduct, and you now have a home office deduction since you are running a business out of your house (so a part of your mortgage, utilities and the maid are being deducted from taxes as well). After 15 to 30 years (ours are 15), you own the units. So, how much did those houses cost you? They cost you 10% (plus loan closing costs) plus your time (usually the time it takes to deposit the rent check, and write the mortgage check and mail it; though sometimes more for sure). We use $25k of depreciation a year, which saves us about $10k a year in taxes. Add that up for 27.5 years = $275,000 in taxes alone in just depreciation.

Your outlay for 3 $200,000 duplexes? 3 * $25,000 (down+closing) = $75,000 for that you get $600,000 of assets. These are more like 15% dollars (compared to the 100% dollars in the market).

Real Estate is not easy, it takes work, but there is no way that the market beats real estate. The stock market carries fees and taxes. Real estate requires real effort, and saves huge on taxes. Oh, and someone else pays the majority of the investment…

Question is; why is it that you pretty much only hear of investing in the stock market?

Hi, this might have been asked and answered before, but I have a question about your method. Maybe you can point me to the answer if you’ve gone over it.

I’ve had good results using momentum investing in stocks, and I am very interested in getting into no-load funds. However I don’t think the same methods I’ve been using for stocks apply exactly. You say you use a mathematical scoring system:

The investing strategy I use assigns a score to no-load mutual funds based on their 1, 3, 6 and 12 month returns. I will remain parked in cash until markets show consistent upward momentum trends, triggering the scoring system to indicate positive numbers again.

If there is a persistent turn contrary to the trend, I follow a mathematical signal and exit that trend.

I’ve looked into the Dal system and I’m wondering if this is what you mean by the scoring and mathematical signal (meaning they do the math), or do you have your own system(s) that you use in addition to the grades that Dal publishes. Also, maybe you could go into a bit more depth about your entry and exit marks. Does this apply to the Dal scoring?

Thanks, as I said I am a big believer in the momentum system and actually managing my money. The post you reprinted here was one of the first that got me into your blog, I’d love to read more like it!

I’ve been spouting for years that Wall Street investing is a sucker’s game. Has been since 1929. Until Wall Street is regulated (hopefully Obama will accomplish this) the odds will always be stacked up against you. All those millions and millions of ‘little people’ who monthly sent their hard earned money into Wall Street investments, only to have those thieves misappropriate the funds. Of course the ‘professionals’ advise you to ‘buy and hold’. It’s a Fool’s Game.
I put all of my money in FDIC banks since 2001 (after the Dot Com bubble and after suffering losses in the Stock Market Crash of 1987). Retirement IRA’s are insured up to $250K per person in banks. I have laddered CD’s in FDIC Roth IRA’s for both myself & my husband. Combine this with 2 real estate properties that I own (without mortgages) and I haven’t lost a single penny during this Great Recession. (one property is a rental) I’ve been able to maintain my millionaire status during the greatest downturn in American history since 1929.

How did I manage this accomplishment? By bucking the herd and all the trends. I trust my own instincts and experience.

Which investment do I love more: the real estate, of course. My main home has appreciated 105%. Even in this housing bubble, I still doubled my money. The rental property has gone down in value BUT the rental income more than makes up for any losses.

During the last housing decline in 1985, I bought a home in the Hamptons, Long Island, NY for only $135K (it’s original asking price was $250K). I held onto it for 16 years (while enjoying a fabulous lifestyle) and sold it in 2001. I made enough in equity to buy 2 more homes (for cash) and retire. I haven’t worked for ‘the man’ since 2001.

People have that same opportunity I had, today. You can buy a home at a reduced price plus get a $8000 tax writeoff (thank you, Obama). I recommend 20% down and a 30 year conventional mortgage, living there for many, many years and never, ever borrowing out your precious equity.

Is this a get rich scheme? Quite the contrary. I’m fond of long term planning. Life is long. Enjoy it!

I’d also like to hear about your formulas and their theoretical justification. I see some of your reasoning, but I’m skeptical that you can see indications of a change in momentum before you lose your money.

You say that you watch the sheep at the front of the herd, but how do you know you’re not at the front yourself? Is it possible that it’s just a matter of time before you suffer a big loss with this technique?

The buy and hold strategy is working just fine for me. Of course it really depends on what you buy and what you hold. I buy shares in quality companies- businesses that earn profits every quarter. These businesses love downturns since many of the weak and unproductive competitors are eliminated.

Correct, I use FundX scores to tell me when to upgrade and to what. There are a variety of ways to use the mathematical scores they provide (by subscription), but as far as I know, they don’t suggest moving completely out of equities during economic downturns (as I chose to do). As I understand it, though, they’ve been experimenting with this option, and have/are creating new managed funds that are more strategic.

In the end, you need to decide what makes sense to YOU and match your comfort level.

Chris wrote: “Also, maybe you could go into a bit more depth about your entry and exit marks. Does this apply to the Dal scoring?”

Basically, as virtually EVERY FundX score turned into a negative number (over the course of the 1st half of 2008) and there were no positive scoring funds to upgrade to, I exited. I will enter again, incrementally, as scores become positive numbers.

As I recall, Dal suggested that investors keep upgrading to the best scores, irregardless of whether they were in positive or negative territory. This didn’t feel right to me, so I opted out. (No one cares about my money as much as I do….!)

How have you fared during the recent (post March 9th) rally? At what point did your scoring system get you back into the market (if it has already)? If not, how do you reconcil missing out on the 30% rally with the notion that momentum investing is not market timing?

Second question – what sort of transactions fees are you running into by moving into and out of the variety of funds?

Every system/style is good and bad, but you have to know when to ditch that system/style so you don’t get the bad. The problem with buy-n-hold is that its first rule essentially says, “don’t ditch the system.” No system is fire and forget and the free lunch promised to all the 401kers, through buy-n-hold, should have been an early warning.

One key thing I learned from Van Tharp is risk/money management. Once you have that determined and in place, the strategy for getting in/out of the market isn’t so important. Even random stock picks can make money with the appropriate risk strategy. (riding the winners, selling the losers)

While I really like ETF’s for the occasional ‘side bet’ or longer-term investment I have been successfully utilizing mainly ‘out-of-the-money’ credit option spreads on indexes for most of this year. My monthly yield has been climbing and is now around 3-5% per month per trade. Compound that monthly and throw in monthly contributions and before you know it you’re talking real money! Plus I’m taking advantage of time decay and I don’t have to worry as much about market direction. I made money down to the bottom in March, I’m making money on the way back up, or even if there is NO trend and the market moves sideways for awhile. I can stay more fully invested.

My firm matches individuals to financial advisors and we are definitely seeing more clients (and advisors) looking for an alternative to buy and hold. However, that doesn’t mean it’s out entirely. Many of these people simply had too much of their portfolio (80%+) in stocks because they were too greedy or optimistic for their actual risk tolerance. Many of them could have stuck with buy and hold if they had a lower equity weighting and were more diversified in cash and other investments.

I’m a buy and holder, I have been through 2 stock market crashes and while my protfolio or my “net worth” has gone up and down they all still pay dividends. If you investing rather then speculating arn’t you buying a business rather than a share? Don’t listen to the talking heads yelling at you buy buy buy, and I don’t listen to experts either. If it’s a good business it’s a good business (that you understand) and their paying a good dividend why should I sell?